Three Huge Red Flags for the Airlines, Hotels

The airline industry is a good barometer of global economic activity as it not only gauges leisure travel but also business activity. We picked up three important red flags recently that may weigh on shares of the airline group (and by extension the hotel space). For those that don’t know us, we’re not at all fans of the investment prospects of the airline industry, but nonetheless, we pay very close attention to airlines for unique economic insights. Read about our recent call on cyclicals here, in case you missed it.

1. Ebola. According to CNN, the first case of Ebola has been diagnosed in the US. Just like the SARS and West Nile virus before it, the news will likely impact air travel, at least in the near term and assuming the outbreak is contained. According to the Centers for Disease Control and Prevention, the patient currently being treated in Dallas, Texas, flew to the US from Liberia. Not only has this person reportedly been in contact with other travelers on the flight and the paramedics who transported the patient (and the ambulance which stayed in use two days after transport), but some school-age children have also been in contact with the Ebola patient. The International Air Transport Association had the following to say about the outbreak:

An Ebola virus disease (EVD) outbreak has been reported in Sierra Leone, Liberia and Guinea. The International Air Transport Association (IATA) is coordinating closely with the World Health Organization (WHO) and the International Civil Aviation Organization (ICAO) with respect to potential implications for air connectivity.

WHO’s current risk assessment for travel and transport is not recommending any travel restrictions or the closure of borders at points of entry. Further, the WHO states that “The risk of a tourist or businessman/woman becoming infected with Ebola virus during a visit to the affected areas and developing disease after returning is extremely low, even if the visit included travel to the local areas from which primary cases have been reported.

In any case, we don’t think discretionary travel will occur at the same pace that it otherwise would if it were not for the Ebola outbreak. We would expect demand to wane in the near term for the larger global network carriers including American Airlines Group (AAL), United Continental (UAL), and Delta Air Lines (DAL). Though less-directly impacted due to their more point-to-point US-focused route networks, JetBlue (JBLU), Southwest (LUV), Alaska Air Group (ALK), and Spirit Airlines (SAVE) may also feel a pinch. The outbreak comes as Southwest is planning to abandon capacity discipline, something that we think is absolutely critical to propping up fares (unit pricing) and keeping load factors (occupancy) elevated across the industry. The fallout could be worse than expected.

2. Unusual Cancelation of $5 billion order with Boeing (BA). For those unfamiliar with the commercial aerospace industry, the backlogs at the airframe giants Boeing and Airbus (EADSY) are jam-packed, with delivery slots filled up for at least the next 12-18 months, and maybe longer should customers have the opportunity to take delivery sooner. Because airplane demand is so robust, it is more likely for a customer to defer delivery of an airplane than to cancel it altogether. This is what makes Air Berlin’s (AIBEF) recent cancelation of $5 billion worth of Boeing aircraft at list prices a bit peculiar.

Even during the Financial Crisis, when access to credit was nearly impossible, we saw airlines simply defer planes, not cancel outright. Further, the cancelled orders included 15 of Boeing’s next-generation 787s, which for the lack of a better phrase, have been flying off the assembly line (customers can’t get them fast enough). The canceled order also included 18 Boeing 737 aircraft.

At the moment, we’re not worried about Boeing fundamentally, but we’re still listing the unusual cancelation as a red flag. Shares of Boeing usually trade with commercial orders, so investors in the aerospace giant should take notice of this development.

3. Strength of Labor. The number of labor stoppages in the airline space has increased as of late. Pilots of Lufthansa (DLAKY) walked off the job yesterday over a wage dispute. It appears that the union is threatening more action as well. Similarly, Air France (AFLYY) pilots recently engaged in a two-week strike in part over the growth of the firm’s low-cost operations, which the union believes will hurt their pay. Though the Air France pilots ended the strike on Sunday, reports indicate that the two-week labor stoppage cost the airline ~$355 million.

We usually see wage pressure near the peak of economic cycles, and as wages are reset higher, airlines become ill-prepared to deal with challenges during downturns, as demand and pricing inevitably wane. This is why airlines can be considered ultra-cyclical, speculative vehicles and tied to an inevitable boom-and-bust flight plan. More airlines have declared bankruptcy than companies in any other industry.

Wrapping It Up

We do not hold any airline in the Best Ideas portfolio or Dividend Growth portfolio, and we’ve already removed aerospace suppliers Astronics (ATRO), EDAC Tech, and Precision Castparts (PCP) from the Best Ideas portfolio—three of our favorite aerospace ideas. We may look to add Astronics and Precision Castparts back, but only at the right price and only when the dust settles. We are not interested in taking on any hotel operator at this time and point to the group as overvalued. Hyatt (H), Intercontinental (IHG), and Starwood (HOT) are on the list of the top 25 most overvalued stocks in our coverage universe.

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